Calculating the Preference Claim in a Chapter 7 Liquidation

Garner v. Knoll, Inc.—the mathematics of a hypothetical liquidation analysis

A preference payment is subject to recovery by the debtor’s estate. Having to return a “preference payment” may come as a surprise. In this case, the issue before the court is whether a creditor received far more than what it would have received under a Chapter 7 liquidation. The case illustrates the mathematics used in conducting (a basic) hypothetical liquidation.

Chapter 7 Liquidation

Knowing addition and subtraction is a skill that is helpful for valuation, forensic work, and damages calculations.  The skill is also useful when one needs to calculate whether a creditor received more than what it/ he or she would have received in connection with a liquidation.  Garner v. Knoll is a case from the Northern District of Texas that provides an overview of the math done in these types of disputes.

The facts in the case are as follows. In 1997, a group of investors purchased a company that became known as Tusa Office.  In 2005, in an attempt to diversify its business, Tusa acquired a retail pre-owned furniture dealership by the name of Office Expo, Inc.  In connection with the acquisition, the shareholders form a holding company, which acquired the stock of the respective companies.  Following the acquisition of Office Expo and the formation of the holding company, Tusa Office became a force in the Northern Texas furniture business.  It was one of the largest dealers of Knoll products. To facilitate sells, Knoll entered into financing arrangements with Tusa customers. 

Unfortunately, Office Expo’s performance never measured up, and Tusa Office began to use its own revenue to keep Office Expo afloat; cash was wired on a weekly basis to pay vendors or make payroll.  This created a liquidity crunch for Tusa.

Tusa restructured its debt with Knoll and also entered into a Loan and Security Agreement with Textron Financial, Inc. (Textron).  This loan agreement with Textron provided Tusa a revolving credit line of $6,500,000 in exchange for a first-priority security interest in all of Tusa Office’s assets, including the Knoll collateral.  The Textron loan agreement also required that Tusa Office’s customers send payments directly to a Textron lock box.

Within five months of the above, on October 31, 2008, Office Expo and the holding company filed voluntary petitions for relief under Chapter 11 of the Bankruptcy Code (Code). On November 5, 2008, Tusa filed its own voluntary petition for relief under Chapter 11. 

On January 30, 2009, Knoll filed its proof of claim in the amount of $6,929,787 in the bankruptcy case.  The financial condition for these entities deteriorated rapidly and the court converted the bankruptcy case from Chapter 11 to  Chapter 7.

In the months leading to the filing of the petition, November 4, 2008, Tusa Office continued to order product from Knoll pursuant to an Amended Payment Agreement to fulfill orders it received. In addition, Knoll continued to ship product and subsequently invoice Tusa for each order it shipped. In turn, Tusa Office continued to make payments to Knoll from the Operating Account to satisfy these “Prepetition Invoices.” 

Two years later, on November 4, 2010, the trustee filed an adversary proceeding seeking to avoid, as preferential transfers, the payments made by Tusa to Knoll relating to pre-petition invoices totaling $4,595,483.¹  The Chapter 7 trustee also sought to avoid as preferential transfers, assignments of receivables made by Tusa Office to Knoll in the amount of $1,161,699. 

A preference is a transfer that enables a creditor to receive a payment of a greater percentage of his claim against a debtor than he would receive if the transfer had not been made and he had participated in the distribution of the assets of the bankrupt estate. Union Bank v. Wolas, 502 U.S. 151, 160-61 (1977).  The elements of a preference are set out in section 547(b) of the code, which provides in part that:

(b) Except as provided in subsections (c) and (i) of this section, the trustee may avoid any transfer of an interest of the debtor in property—

                        (1)       to or for the benefit of a creditor;

(2)       for or on account of an antecedent debt owed by the debtor before such transfer was made;

                        (3)       made while the debtor was insolvent;

                        (4)       made—

(A)       on or within 90 days before the date of the filing of the petition; or

(B)       between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider; and

(5)       that enables such creditor to receive more than such creditor would receive if –

(A)       the case were a case under chapter 7 of [the Code];

                                                (B)       the transfer had not been made; and

(C)       such creditor received payment of such debt to the extent provided by the provisions of [the Code].

In short, an analysis requires the court to construct a hypothetical Chapter 7 liquidation and determine what the creditor would have received had the transfers not taken place. So was the $4,592,483 in payments relating to the pre-petition invoices a preference, which would require Knoll to return this amount to the Trustee?  While the trustee suggested that such a hypothetical liquidation was not necessary under the In re El Paso Refinery, LP, 171 F.3d 249 (5^th Cir. 1999), Knoll contended that the trustee’s reliance on El Paso Refinery was misplaced and that a hypothetical Chapter 7 liquidation was required by the code.

In El Paso Refinery, the Fifth Circuit opined that “[t]o determine whether an undersecured creditor received a greater percentage recovery on its debt that it would have under chapter 7 the following two issues must first be resolved: (1) to what claim the payment is applied and (2) from what source the payment comes.”  These are known as the “Application Test” and the “Source Test.”

Briefly, under the Application Test, if a payment is made to an undersecured creditor, and such payment is applied to the undersecured portion of the debt, then the undersecured creditor will have recovered a greater percentage on this claim if the estate cannot pay its unsecured creditors 100 percent of these claims. In contrast, if the undersecured creditor applies the payment to the secured portion of the debt, the creditor effectively releases a portion of its collateral from its security interest; that is, its secured claim is reduced, freeing up a corresponding amount of collateral. , In this situation, the creditor does not receive a greater percentage recovery. If, however, the creditor does not actually release collateral upon application of the payment, then the payment is on the unsecured portion of the claim.

Here, the debtor was unable to pay its unsecured creditors 100 percent of their claim. In addition, Knoll did not release collateral upon receiving payments from the debtor. In fact, Tusa Office’s indebtedness to Knoll was in excess of Knoll’s collateral at all times during the preference period. It follows, that the payments were in fact payments on the unsecured portion of the claim. 

In addition to satisfaction of the Application Test, the Fifth Circuit also requires that a trustee satisfy the “Source Test” before a court can determine that a creditor received a voidable reference.  The Fifth Circuit states that even if a payment in question has been applied to the unsecured portion of an under-secured creditor’s claim, the creditor will not be deemed to have received a greater percentage as a result of the payment if the source of the payment is the creditor’s own collateral. The Fifth Circuit’s position here is that a creditor who merely recovers its own collateral receives no more than it would have received anyway had the funds been retained by the debtor, subject to the creditor’s security interest.

As applied here, the key question before the court was whether the source of the preference period payments was Knoll’s collateral.  Here, the parties did not dispute that the proceeds of Knoll’s collateral were deposited in the lock box. The trustee asserted that because Textron swept Knoll’s collateral from the lock box and applied it to reduce the indebtedness owed to it by the debtor; the subsequent funds Textron released to Tusa Office were new and unencumbered funds for Tusa Office to spend at its own discretion. The trustee asserted that the source of the preference period payments was not Knoll’s collateral, but the unencumbered funds periodically given to Tusa Office.  The court rejected this argument.

The Math Exercise: The Hypothetical Liquidation

The court determined that Tusa’s hypothetical liquidation value on the pre-petition date was $9,713,392.²  On the petition date, Tusa Office’s secured claims consisted of:

The priority scheme provided by code section 507 is instructive to determine how distributions would have been made.  Under this scheme, $653,137 in tax claims would have been paid out of the debtor’s estate ahead of general unsecured claims, leaving $9,060,625 to be distributed to Tusa Office’s creditors. Of the $9,060,625 remaining in the debtor’s estate, $4,322,501 would be paid to Textron on account of its first priority lien, leaving $4,737,754 remaining in Debtor’s estate.  Of the $4,737,754 remaining, $3,081,713 would be paid to Knoll in full satisfaction of its first lien claim, which would leave $1,656,041 in the debtor’s estate. The remaining $1,656,041 would be subject to Knoll’s secondary lien and thus the entire amount would be paid to Knoll in partial satisfaction of such secondary lien. 

These calculations indicate that Knoll would have received $4,737,754 from the debtor’s estate on account of its first and second lien collateral positions. Therefore, had Knoll kept the preference period payments, it would have received a total amount of $9,330,237.90 had Tusa Office filed a case under Chapter 7; $4,737,754 (Knoll’s total recovery) + $4,595,483.90 (preference period payments) = $9,330,237.90.

In calculating what Knoll would have received had the preference period payments not been made, the preference period payments must first be returned to the debtor’s estate, which would increase the available amount for distribution to creditors to $14,305,875.90; $9,713,392 (Debtor’s liquidation value) + $4,592,483.90 (Preference Period payments) = $14,305,875.90.

The court opined that: 

Utilizing the priority structure [], it is clear that Knoll would have still been paid $9,330,237.90 had the Preference Period Payments not been made.  To illustrate, $653,137 would still be paid out first to satisfy the Tax Claims, leaving $13,652,738.90 to be distributed to Tusa Office’s creditors. Of the $13,652,738.90 remaining in Debtor’s estate, $4,322.501 would have been paid to Textron on account of its first priority lien, leaving an amount of $9,330,237.90 remaining I Debtor’s estate. Of the $9,330,237.90 remaining, $7,674,196.90 would be paid to Knoll in full satisfaction of its increased first lien claim, which would then leave an amount of $1,656,041 remaining in Debtor’s estate. Again, the remaining $1,656,041 would still be subject to Knoll’s secondary lien. So, even if the Preference Period Payments were returned to Debtor’s estate, Knoll would still have received a distribution in the amount of $9,330,237.90.

Under this analysis, Knoll would not receive more by keeping the preference period payments that it would under a hypothetical Chapter 7 liquidation.

While the case law cited controls in the Fifth Circuit, the case provides an overview of what is a deemed a preference and illustrates the mathematics involved in a hypothetical Chapter 7 liquidation.  As a side note, this case also illustrates the importance of a valuation in this analysis and underscores the importance of quickly “exiting” a business that is not self-sustaining. 

This article was previously published by Wasatch Business Valuation & Litigation Support Services, LLC.

¹ The Chapter 7 Trustee filed a complaint with seven counts.  The Trustee claimed avoidance was warranted pursuant to Code sections 547, 549, 544(a), and 362(k); recovery was sought under Code section 550.